What can management do to avoid becoming the next short-seller roadkill?
With 417 funded SPACs currently in search mode for the perfect private company to merge with, 2021 is becoming the “Year of the de-SPAC” following the “Year of the SPAC” in 2020 that carried over into the exuberance of the first quarter of 2021. These SPAC sponsor teams are sitting on about $140 billion of capital in trust, supplemented by tens of billions more in PIPE investments, which could theoretically generate a trillion dollars of market capitalization for newly formed public companies.
To activist short-sellers, that smells like $1 trillion of opportunity as what they view as poorly prepared, subpar companies with inflated valuations are launched on the public markets after taking down some high profile SPAC mergers, including Nikola, Lordstown, XL Fleet, and MultiPlan.
Companies concerned about becoming the target of a SPAC short campaign must position themselves as credible companies with bulletproof disclosures. Highly promotional or exaggerated claims and projections may work to crank up the stock price in the short term with credible retail investors, but that is simply setting the company up for disaster down the line. Given the embarrassment caused by high-profile SPAC flameouts, the SEC is also now subjecting companies to a much higher degree of scrutiny that can hold up the completion of a merger if disclosures are deemed inadequate by the examiners.
SPACs have the potential to be a game-changer for ordinary investors, enabling them to get in on the “ground floor” of disruptive, rapidly scaling businesses that would typically be the preserve of VC and private equity firms. But while their business models may be at an earlier stage of development, the fundamentals of being a well-prepared public company — good corporate governance, solid fundamentals, accurate and timely financial reporting — will ultimately dictate the success and failure of these enterprises and returns for public shareholders.
Why SPACs Make Attractive Short Targets
SPACs are attractive short targets for several reasons. Their often inflated market capitalization and relatively fragmented shareholder base make it easier to borrow shares short, a fundamental component of short selling.
Short-sellers make money when stock prices fall, and the 50 largest U.S.-based pre-merger SPAC deals have collectively slumped nearly 4% to date. Investments betting against these so-called “blank-check companies” were up more than $500 million in April, according to The Business Insider.
The post-merger side isn’t looking much better. The CNBC SPAC Post Deal Index, composed of the largest SPACs that have come to market and announced a target, has fallen nearly 14 percent this month. Meanwhile, the dollar value of bearish SPAC bets has more than tripled this year, according to a recent report from S3 Partners.
SPACs are also attractive because they are a source of plentiful untested companies with relatively sizable market caps. America’s roster of public companies steadily shrunk from the mid-1990s onward, but the trend has recently reversed to the pleasure of short-sellers. Interest in shorting SPACs has risen in line with their share price, drawing significant looks from traders hoping to leverage an overbought area of the market.
What Short Sellers Look for in a SPAC
Short-sellers, who provide efficiency to the market by sniffing out where management may be overly optimistic about prospects, view the current SPAC landscape as a target-rich environment. When considering whether a SPAC merger is an attractive short candidate, sellers first look at business fundamentals and historical financials to determine whether the company appears to have a viable business model.
“We look at the ‘story’ being sold to the Street,” explains Dan David of Wolfpack Research, asking first if it is realistic that a SPAC target will hit the aggressive projections used to sell their story. “Is the Total Available Market (TAM) even big enough to support those numbers? We also look at the management of the operating company and SPAC sponsors to determine if they have a history of doing shady or illegal things.”
Are the sponsors or target management highly promotional or overly quick to dump shares into the market? Short sellers are on the lookout and ready to pounce.
Carson Block, perhaps the most famous short-seller of his generation, first asks if the information companies release is materially accurate. “Has there been a lie of omission?” he wonders, pointing to a “ridiculous” SPAC he recently targeted (an electric vehicle fleet electrification company called XL Fleet Corp), which was less than forthcoming about projected sales. “They were saying, ‘We did $7 million in revenues in 2019, and we’re going to do $1.4 billion in 2024.’ I was like, Really?”
Block described the intellectual calisthenics required to convince investors to swallow the $7 billion projection - citing a pipeline of $220 million, which Block claims was grossly exaggerated. Even the customer logos XL presented were squishy, given that many of them had not submitted any additional orders. Companies hoping to avoid the predatory gaze of short-sellers would do well to avoid such pitfalls.
Unsurprisingly, SEC is honing in on forecasts given the recent spate of bad actors and outright frauds spinning works of fiction about their anticipated success. Some short-sellers, like David, keep a checklist handy to help him decide whether to continue pursuing the target.
“Given there are so many puffed-up SPACs, we need to focus where it is an open and shut case,” he explains, pointing to additional red flags:
- Are there going to be a ridiculous number of warrants being exercised and dumped into the market offering a tailwind to ride?
- Are there highly questionable or undisclosed transactions?
- Did they make a change in revenue recognition or other key accounting policies in the run-up to the deal to pump up their results?
- Also, are they in a crowded space with big competitors that have not been disclosed to investors?
On the other hand, David is likely to take a pass on a company viewed as fraudulent if there is already a significant short interest combined with a highly concentrated institutional shareholder base. Those technical elements can set up a “short squeeze” where even questionable companies can engineer a run in the stock with the help of funds. “Even if the company is outright, indefensible fraud, we don’t want to position ourselves technically where someone could execute a short squeeze. Been there; don’t want to repeat it.”
When is a Campaign Most Likely to Be Launched?
Post-de-SPAC companies are desirable to short because of the larger market capitalizations and because early investors in the SPACs are eager to sell shares to lock in profits.
Short campaigns are also likely to be launched in the wake of a significant stock increase. For example, Kerrisdale Capital founder Sahm Adrangi started shorting post-merger SPAC companies, predicting a trend of people de-risking return to earth many high-flying SPACs. His recent bet against Richard Branson’s high-flying meme stock Virgin Galactic has been less successful thus far.
How Do Companies and SPAC Sponsors Make Themselves Vulnerable?
Companies with flawed accounting, unrealistic projections, and questionable business milestones make themselves unnecessarily vulnerable. Amateur investor communication doesn’t help, either.
But management and SPAC sponsors needn’t live in constant fear of being targeted by a short campaign, so long as they keep their accounting sound, their disclosures accurate, and (fingers crossed) their sales growing at a healthy clip. Nothing makes short sellers squirm more than solid operating performance.
If and when a short-seller report drops, management should be straightforward in responding to the allegations. “Keep it short and simple,” David says, suggesting to “knock the legs out” of the thesis with specific facts and data. If a report contains a fundamental misunderstanding of a company’s business model or accounting policies, management should quickly defang the argument and substantiate the scale of the business.
The worst thing to do is engage in ad hominem attacks, conspiracy theories, and filing lawsuits, David continues. “That tells us that a) the company has a real problem and is desperate b) they have no problem burning shareholder cash on a suit they will not win, and c) they are probably dumping into the market through some channel. If anything, that would give the conviction to double down.”
If the scope of allegations is limited to a particular business segment, the audit team should investigate if transactions were improperly recorded. Audit partners need to demonstrate that they adhered to audit standards in their work and were not negligent since every prior decision will now be placed under a microscope. Further investigation is warranted to detect undisclosed conflicts, scrutinize backgrounds of management and promoters, and determine whether business relationships and technology have been over-hyped.
Towards a Healthy SPAC Ecosystem
SPAC IPOs had an astonishing run in 2020 and Q1 of 2021 as investor enthusiasm for product enabled sponsors to mint money. Many sponsors have made tens of millions of dollars off these transactions, and companies have gotten public years before the traditional IPO market would accept them.
With hyper-growth, disruptive business models, there is also a higher probability of failure. Investors need to understand that investing in late-VC-style deals will result in a distribution of moonshots and crash landings. That said, once the target companies elect to enter the public markets, they need to meet the same standards for truthful and complete disclosure, timely and accurate reporting, and mature governance of any other public company.
Done right, the SPAC could be the catalyst to revive new public company formation in the United States and reassert our position as the deepest and most dynamic capital markets in the world. Done wrong, it will be one more obscure financial innovation that people would prefer to forget as they nurse their losses.